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The sharp downward turn in equity markets due to the pandemic and eventual global quarantine caused volatility to spike to a record high. Abrupt increases in volatility seem to always elevate interest in a segment of investing that is more fantasy than reality: day trading. The allure of making quick profits in the stock market has been around since its existence. However, the success of this segment is few and far between and should never give way to long term investing with an objective that aligns with a strategic goal.
Day traders typically demonstrate volatile swings in their accounts, causing individuals to lose the ability to grasp the increase or decrease in their accounts in percentage terms but focusing only in dollars. Eventually, they lose sight on the amount of risk they have to take in order to break even or show a profit, leading to inefficient and dangerous investments. Lately, social and television media have promoted this type of investing by glorifying a few certain successful traders and pointing to its popularity by referencing the surge in the number of accounts opened on Robinhood, a brokerage platform that offers free trading. Unfortunately, day traders are like restaurants, you only hear of the few successful ones but never hear of the hundreds that have failed.
The two substantial reasons why we believe short-term speculative trading is inferior to long term investing are taxes and behavioral concepts. Short term realized gains are taxed at ordinary income rates that are higher than long term capital gains rates.
The second most dominant factor why long term investing is superior to short term trading involves behavioral characteristics. How many people out there would see their account values drop heavily in a short time period and panic? How many of you would sell out of the markets at the wrong time because you took too much risk in the first place? Difficult for many to honestly answer that question, but we know how the majority of individual investors would answer those questions. In fact, a white paper written in 2011 titled “The Behavior of Individual Investors” by Brad M. Barber and Terrance Odean was written documenting how individuals underperform due to behaviors that they portray, inhibiting successful investing. One of them is called the disposition effect, selling their winners and holding on to their losers, thus incurring a high tax liability. Here are a few of the other negative behaviors commonly exhibited by the average speculative individual investor:
- Overconfidence – tendency to hold a false assessment of your own skills and talent. The trader believes he is better than he really is, thus taking too much risk in the portfolio.
- Familiarity – tendency to invest only in things they know, resulting in a portfolio that is not diversified which would help to decrease risk.
- Chasing the action – daily media updates on stocks that have large movements grab the trader’s attention. Stocks that continue to rise during the day attracts the individual investor causing them to chase stocks that have run up in price past their fundamental values.
It is paramount for investors to not fall into the hype of successful day trading as a viable option to make money in the markets. Day trading leads to undiversified portfolios exposed to risks the trader may not even understand. We find long term strategic allocations to a basket of diversified, risky assets with rebalancing mechanisms in place overcome the two leading drawbacks to short term speculation. An investor’s tax bill will be much lower, and the investor can avoid behavioral traits that only damage long term returns. Overall, many different types of investing exist. When it comes to day trading, I warn you… don’t believe the hype.
About the Author - David Navarro, CFA®
David Navarro, CFA® is the Director of Research at West Capital Management, a subsidiary of WSFS Financial Corporation. West Capital Management focuses on developing custom planning and investment strategies tailored to each client’s unique circumstances and greater ambitions. David graduated with a B.S. in Finance from Rutgers University. He can be reached via email at email@example.com.
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